Krispy Kreme Doughnuts, Inc Case Solution

1. What can the historical income statements (case Exhibit 1) and balance sheets (case Exhibit 2) tell you about the financial health and current condition of Krispy Kreme Doughnuts, Inc.?

The historical income statement shows that the revenues are increasing while operating expenses are also on the rise due to its acquisitions and expansion of stores. Income from operations has increased while interest income has gone down, possibly due to the closure of a few franchises, which is a concern for the company. Interest expense has increased a lot indicating a high loan and certainly not a positive sign for the health of the company. Income before taxes and Net Income has increased at a good rate which shows the positive condition of the company and good financial health on Feb. 1, 2004. However, for the next two quarters, Income before taxes and Net Income has decreased compared to the comparable quarter in 2003 which shows that the financial condition has deteriorated. The company has shown a loss of $24.438 million on May 2, 2004.

The balance sheet indicates that the company is facing problems regarding its cash collections as Accounts receivable and Accounts receivable affiliates along with other receivable have increased a lot. The company has invested heavily in Property Plant and Equipment. The major problem here is that the company has not amortized its reacquired franchise rights and hence assets were overstated, and net income is also overstated.

Looking at both income statements and balance sheet, the company’s financial health is not very good as it is facing the issues regarding the accounting treatment and after this adjustment, net income would decrease.

2. How can financial ratios extend your understanding of financial statements? What questions do the time series of ratios in case Exhibit 7 raise? What questions do the ratios on peer firms in case of Exhibits 8 and 9 raise?

Financial ratios can explain the financial ratios by looking deeply into the liquidity of the company, its profitability, its cash conversion cycle, its financial leverage and overall financial health of the company.

Liquidity ratios indicate a pretty good condition of the company and show that the company has the ability to pay its short-term obligations. Debt to Equity increased in 2003 due to heavy loan taken by the company. Hence, interest expense has increased, and Times Interest Earned has decreased. The decrease in Asset Turnover is not a positive sign for the company when it is heavily investing in Property Plan and Equipment.

The overall position of the company shows a concern due to its high financial leverage. Profitability ratios indicate a very strong position of the company, but as it is evident that the Net Income of the company is overstated due to the accounting error, these rations would decrease after the adjustment.

In comparison with the Industry, liquidity of the Krispy Kreme is much better than all of the other players. Its LT debt to equity and LT debt to total capital ratios are pretty good in comparison to the industry, but its interest coverage before tax is very much high than other companies in the industry and it is the area of concern for Krispy Kreme. As already discussed, the company is not using its assets efficiently; its asset turnover is not very good in the industry. As far as its profitability is concerned, these ratios would decrease after the adjustment and would not look better in comparison with its competitors. In comparison to Starbucks, it has very low activity ratios which indicate problems in its profit-making model and inefficiencies in using its assets. It has generated profits through increased fees charged on franchises rather than through its operations. Starbucks stands very well above Krispy Kreme in case of portability ratios, as well. 

3. Is Krispy Kreme financially healthy at year-end 2004?

As discussed above, Krispy Kreme has high net income at year-end 2004 with the apparently good financial condition, but it is facing problems regarding its financial health. Company has a net income of around $57.087 million with high EPS of 0.92 as compared to the previous years with share price of around $35.64. Its liquidity position is also quite good. However, activity ratios at the year-end are showing a cause of concern. These profitability numbers, share price, and EPS indicate apparently good financial health, but the company has much deeper problems which caused serious issues for the company in the next quarters. These issues caused the share price to decline.

Net income has been overstated by between $6.2 million and $8.2 million as the reacquired franchise rights have not been amortized. Interest coverage has increased, and it has invested heavily in high-profit margin equipment along with increasing no of stores which is causing problems for the company. The company had to divest Mountain Mills in the first quarter of 2005 which caused Krispy Kreme to report a loss of around $24.438 million. With issues related to SEC investigation and decrease in return on invested capital as a result of restatement of the financial statements, its focus on profits through high-profit margin-equipment and other management issues, it can be stated the company does not look financial healthy as there are deeper problems in the company which have caused the share price to decline.